Capital Structure For Start-Ups: Part I

By: Robert V. Hawn

As a corporate attorney in San Jose, California, I help a lot of high tech start-up companies get up and running. One of the major decisions that requires a lot of time and discussion is how the new corporation should set up its capital structure. In this series of blogs, I hope to explain some of the basic issues and concepts to help founders understand how to approach building this important aspect of their new business.

Closely Held Corporations

Corporations are formed to enable founders to accept outside capital by selling ownership interests, or shares, in the corporation. Remember, stock is merely a share of ownership in a corporation. Shares that aren’t sold or otherwise provided to employees, investors, or others are held by the founders. So, one of the basic issues that a founder will want to know and keep track of is how much of their corporation they own. If you own all of the stock of a corporation, you own the entire corporation. If you just own a third of the stock, then you just own a third of the corporation. Simple, right?

The example above is typical of a corporation that is held by very few people. It is what lawyers refer to as a “closely held” corporation. A closely held corporation is typical where the stockholders are actively involved in the business. Stock rarely changes hands, and it is unusual for new stock to be issued. In that situation, it is easy to determine how much of a corporation each person owns.

Outside Investor

Now, let’s make things a bit more complex. Let’s say that our corporation has three equal shareholders, who bought their shares for $1 each, and an investor has agreed to put some money in the company. After discussion, which, of course should include advice from your corporate lawyer, you decide that the corporation is worth $300, and that the investor can hold ¼ of the corporation, or 100 shares, for $100. Before the deal is done, each shareholder owns 1/3 of the corporation or 100 shares each. There are 300 shares outstanding . After the deal is done, there are now 400 shares outstanding and each shareholder now only holds only ¼ of the corporation, although they still each own 100 shares. This reduction in percentage interest is called “dilution”. If it is a very important concept to remember. It is common to say that your interest in the corporation has been diluted from 33% to 25%, even though you hold the same number of shares. Make sure you understand it before you go on.

What is interesting about the dilution example is that the percentage of the old stockholder’s ownership has gone down, but the value of their ownership has remained the same. This is because the addition of the $100 in investment capital has increased the value of the corporation from $300 to $400. The old stockholder now owns ¼ of a corporation worth $400, and the value of the ¼ ownership remains at $100. (despite the “dilution”).

Stock Options to Key People

In a start-up corporation, the structure becomes a bit more complicated because certain types of interests are issued which can convert into stock of the corporation. Let’s see how that impacts the percentage ownership of each stockholder.

In our example, let’s say we want to provide an incentive to a key employee. One common approach is to provide an option. The cool thing about the option is that the employee doesn’t have to buy their stock until they can get some money for it. So, often, employees just hold onto the option and don’t turn it into stock (a process called an “exercise”) until they need to. By then, they hope the value of the stock has increased and they can make some money. One key concept is that if the option is never exercised, you never get stock, and there is no ownership interest in the corporation. In other words, an option does not represent ownership; only stock represents ownership.

You may want to determine ownership, however, if you are selling your corporation and you know the option will be exercised. So, how do you determine ownership where someone holds an option, but not the stock? Very simply, you assume that the person exercises their option and turns it into stock. Once you do that it’s easy to determine the percentages.

In the example above, let’s say our employee is provided an option for 20% of the corporation, or 100 shares. If you look at just the percentage of the ownership before the option is exercised, then each person holds ¼ of the corporation or 100 shares out of 400 shares. When the option is exercised, however, there are now 500 shares outstanding. Each stockholder holds 100 shares, or 20% of the outstanding stock.

The number of shares of stock determined assuming options have been exercised (among other things), is called the fully diluted number of shares. The fully diluted number of shares is an important concept because it is often used to set the value of a single share of stock in an investment deal. In the next blog on capital structure for start-ups, I will discuss how investor stock affects the number of fully diluted shares, and your percentage ownership.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

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